Natasha de Teran explores Europe’s rocketing corporate credit spreads and the resulting surge for asset-backed securities.

Corporate credit spreads have appeared to be on a seemingly endless positive trajectory. They have narrowed to such a degree that new investment at a time of historically low interest rates appears unappetising at best, and foolhardy at worst. The momentum has naturally seeped over into the asset-backed securities (ABS) market where investors have sought out opportunity.

The growing appetite for ABS soon resulted in spreads in this part of the market beginning to move alongside those in the corporate bond market, leaving little room for yield-hungry investors.

Richard Hopkin, managing director and deputy head of securitisation in Europe at SG CIB in London, says the driver behind this spread compression has been the sharply increased cash allocations to ABS products. He says: “This came on top of the exponential growth in the market in Europe in 2003, when investors finished the year without having invested all their cash.”

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Chris Ames: ‘Investors’ appetite is more dependent on the strength of the structure and the spread on offer, rather than the exposure type’

Demand up

The result has been that demand for mezzanine and subordinate ABS has increased as investors have been driven further up the yield curve in search of incremental pickup. Analysts have backed the more intrepid investors’ moves, recommending they move down in credit and into higher yielding sectors such as commercial mortgage-backed securities (CMBS), non-conforming residential mortgage-backed securities (RMBS), and collateralised debt obligations (CDOs) of ABS as the appropriate strategy in the current market.

Mr Hopkin says that the shift up the yield curve has been ongoing since the beginning of this year, but that it has gathered pace as the year has gone on. There has been a huge amount of cash to be put to work, which has pushed spreads sharply tighter. Although this was firstly more noticeable at the triple A level, investors have since moved further down the credit spectrum to get more yield and to meet minimum return targets.

Birgit Specht, head of securitisation research at DrKW in London, says that demand for lower rated tranches considerably outweighing supply has played a key role in spreads tightening. She says: “Most issues have been several times oversubscribed this year, even at current levels. This indicates that many investors are perhaps not happy – but still willing – to invest at these, and, in fact, at tighter levels, in the absence of better alternatives. In the current low absolute return and low volatility environment, structured credit remains one of the only areas offering a pick-up, despite the tightening of consumer/ granular ABS/MBS and CMBS spreads since the beginning of the year.”

Although 2004 has been a record year of issuance so far – at the end of the first quarter the market was already up by approximately 36% to E55bn in terms of issuance compared with last year – Mr Hopkin says that originators continue to source ample assets to securitise. Others agree. Jason Russell, director on the ABS syndicate desk at SG CIB in London, says: “The market started off very busy this year, went quiet at Easter, and has since been building up again. There is still a lot of demand throughout all rating categories and even into non-investment grade exposures.”

The appetite for securitised assets was made apparent earlier this summer when SG CIB announced a E700m Spanish mortgage-backed deal. According to Mr Russell, the deal was already several times oversubscribed even before pricing details were available.

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Richard Hopkin: ‘In terms of how much issuers are prepared to pay for underwriting, the market remains extremely competitive’

Differing opinions

In attempting to rationalise the increased cash allocation to ABS, bankers’ opinions are varied.

Mr Hopkin says that a number of factors have contributed to it – including a shift away from equities to bonds, the continuing search for high ratings combined with Euribor/Libor plus yields, and assets and structures representing a safe haven.

Mr Russell says that a wider range of appetite for the products will also have helped the tightening. He says some structured investment vehicles are now looking for euro products when they had previously targeted dollars, and how, in addition, there are also a lot of new, dedicated mezzanine investors, either as part of a plain vanilla fund management operation or as CDOs of ABS. “The tightening in financials has been another driving factor. Investors have responded to spread tightening by switching out of that sector and into AAA rated ABS because of the relative value,” he says.

Like Mr Russell, Ms Specht says that the growing number of investor classes involved in the market have also been a factor in its tightening. She says: “Banks have always been buyers of the subordinated tranches, but now there are more fund managers and hedge funds involved, as well as CDO managers, which have been generating sizeable demand for subordinated paper since 2003.”

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Jason Russell: ‘There is still a lot of demand throughout all rating categories and even into non-investment grade exposures’

Bigger timescale

Chris Ames, head of structured credit research at BNP Paribas in London, believes that most of the influential factors have been in place for a longer time. Because the European ABS market has been around for more than 10 years now, the investors that have been involved for longer are now much more educated on and fluent with the products, and are happier buying further down the rating scale. At the same time, new investors are coming in from the corporate investment side, who, having recently suffered rating volatility and defaults in the corporate credit markets, have therefore turned to ABS in growing numbers. The growth of cash CDOs of lower-rated ABS – which absorb a good part of the supply of mezzanine ABS tranches – have also contributed to the growing appetite for this sector, he says.

If the increasing taste for the product is welcome news for bankers, the compressed spreads, increased levels of competition and additional layers of complexity involved in pricing and placing lower-rated deals, might be less so. However, bankers are not put off.

Mr Hopkin says that the competitive pressure on fees has always been present and is neither directly linked to nor exacerbated by spread compression. Moreover, because ABS deals, unlike bond deals, have historically been placed at their true re-offered margins – and outside specific local markets there has been little discounting of fees by banks to get bonds away – there is less pressure. He adds more cautiously: “In terms of how much issuers are prepared to pay for underwriting, though, the market remains extremely competitive.”

Bankers say that the amount of work involved in structuring such deals is neither greater nor less than that in higher-rated transactions. “As bankers, it is our job to understand the whole deal – so there is not really any incremental work for us in selling mezzanine and subordinated, as opposed to senior, bonds,” says Mr Hopkin.

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Birgit Specht: ‘Most issues have been several times oversubscribed this year, even at current levels’

Bankers’ workload

What is more onerous for bankers, however, is the time and effort involved in actually placing such deals. Mr Russell says: “On the credit side, the triple-B and single-A rated paper does take longer to place. Investors ask more detailed questions, and undergo far more rigorous due diligence and credit-based analysis before making an investment decision. You have to do a lot more work to keep the triple B buyers happy.”

Balancing the requirements of issuers who are taking advantage of the opportune financing environment and giving investors the absolute return and allocations they want is another headache that syndicate desks face, according to Mr Russell. “There will be a point where it no longer makes economic sense for investors to look at this market and in some instances return hurdles have been passed. But we have not yet reached a point where demand has fallen off, far from it,” he says.

But if investors demand more time and hand-holding from bankers, they appear remarkably adaptable in terms of the paper they will accept. Mr Ames says investors tend to be fairly flexible in terms of what they are going for. “Some are happier with consumer exposure, but usually their appetite is more dependent on the strength of the structure and the spread on offer, rather than the exposure type.”

Mr Hopkin adds: “As an alternative to taking more risk, some investors have diversified into other more yield-rich asset classes such as CMBS instead. In March, SG CIB launched White Tower, a very successful CMBS transaction in which a large part of the bid was driven by growing demand from yield-hungry investors.”

One of the side-effects of the growing taste for lower-rated paper is a move away from its distribution in the public markets, to private placements. Ms Specht explains: “What has also changed is that there is more appetite formezzanine paper – so much that some of it is now being placed privately, which tends to be easier and more economical for issuers. This contrasts markedly with two or three years ago when it was typically very difficult to place subordinated tranches.”

The question for bankers now is whether the appe-tite for subordinate and mezzanine paper will remain high if spreads stay at their historical low. Syndicate desks – who directly face customers – may be more indifferent to their doing so: after all, it is they who are involved in the day-to-day business of managing customer expectations. Mr Russell, who is one of those closely involved in the task of dealing with the buy side, believes the market is now in a self-perpetuating situation where new investors are creating more demand, which is driving spreads in and reducing allocations.

Here to stay

Mr Ames goes one step further; he believes the recent surge in appetite is not a passing blip, but is a long-term market adjustment.

He says: “This is not a temporary thing – it is a fundamental shift in the investor base. When you invest in these products you need to ensure that there is a widespread understanding of the product. It is not sufficient just for one person within a fund to understand it – management need to understand the product as well. In Europe many investors are now at the stage where there is a good level of understanding of the full capital structure in these deals, right up the management chain. That will ensure that this sector of the market remains a key focus in the future.”

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